The full repercussions of the financial crisis triggered by bad mortgages in the United States are still unclear, but the unforeseen effects already include an unstoppable demand for greater transparency in financial markets, and better regulation.
One part of the financial markets not subject to the transparency and disclosure rules that apply to, say, banks and mutual funds, are hedge and private equity funds. Once relatively small, the five biggest private equity deals now involve more money than the annual budgets of Russia and India.
Assets in private equity and hedge funds stand at $3 trillion today and are expected to reach $10 trillion by the end of 2010. The funds now rely heavily on investment from pension funds, and on money borrowed from banks and other non-private sources.
Indeed, these private funds account for about two-thirds of all new debt. So, if there is a debt problem, as in the US mortgage crisis, one must also look at private funds’ role in creating it. They are, in short, a major challenge to financial stability, and, unless regulated, they are likely to contribute to future crises.
The big private equity funds have proven to be a menace to healthy companies, to workers’ rights, and to the European Union’s Lisbon Agenda (aimed at making Europe the world’s most competitive economy). Typically, they take over companies with borrowed money – often more than 80% of the price. These “leveraged buy-outs leave the company saddled with debt and interest payments, its workers are laid off, and its assets are sold. A once profitable and healthy company is milked for short-term profits, benefiting neither workers nor the real economy.
In Britain, the Automobile Association was bought by private equity in 2004. The AA had made a profit of £75 million and was expanding its services with 10,000 staff. Annual profits have since risen to £190 million, but 6,000 workers have been laid off and both costs and waiting times for AA members needing its vehicle repair and recovery services have increased.
In Denmark, the telecommunications company TDC was taken over by a group of private equity firms in 2005, with 80% of the purchase financed by borrowing. The company’s debt/asset ratio leapt from 18% to 90% as company reserves for long-term development – essential in the telecoms industry – were used to service the loan.
These funds are largely tax-exempt, often because they are registered offshore, although they operate from the world’s major onshore financial centers. One fund manager admitted that he pays less tax than his cleaning lady. In the US, it has been calculated that the funds cost $2-3 billion in lost tax revenues – an amount three times that of the EU’s budget for humanitarian aid.
Trade unions in the United Kingdom, Germany, Canada, and elsewhere have long pointed to the damage caused by leveraged buy-outs. So have such senior politicians as former German Vice-Chancellor Franz Müntefering, who described private equity funds as “locusts, and leading Democrats in the US Congress’s House Committee on Financial Services.
The European Parliament’s Socialist Group, the UK’s House of Commons, and the Australian parliament have all investigated these private funds.
Charlie McCreevy, the EU’s internal market commissioner, is staunchly resisting any move towards greater control of private equity and hedge funds. But the tide is turning against him. At the EU’s autumn summit, British Prime Minister Gordon Brown, German Chancellor Angela Merkel, and French President Nicolas Sarkozy agreed in a joint statement that more transparency is needed in financial markets. In a separate move, Brown promised to close any legal loopholes that enable hedge fund managers to exempt themselves from paying taxes.
Both the private equity and hedge fund industries reacted by publishing voluntary codes of conduct. Paul Marshall, a hedge fund chairman, told the Financial Times that he hoped voluntary action by the industry “will take the pressure off. At least that was transparent.
Nobody wants to demonize or unnecessarily restrict private equity and hedge funds, and venture capital’s investment in innovative and high-risk new companies highlights their potentially useful role. But this accounts for only a minor part (5%) of the private equity industry. Given that the largest part of the industry (60%) is based on leveraged buy-outs and extreme debt, it seems only reasonable to demand that they honor the transparency and tax rules accepted by everyone else.
Ultimately, private funds should be regulated globally. We can enact measures in each of our member states and in the EU, but coordinated action by the EU and the US would be a realistic start. Private funds cannot operate without these two giant markets, and would have to comply with their requirements. The will to act exists in the EU. Faced with the leaders of Europe’s three largest economies, McCreevy is not a serious obstacle. The White House’s current occupant is a more formidable obstacle to reform, but change is coming.
Even so, ensuring transparency and disclosure cannot fully address heavily debt-laden leveraged buy-outs, which would still be objectionable. There is a need to set a limit on the amount of debt that a company can accumulate, and change acquisition and merger legislation to include leverage. The latter clearly falls within the EU’s competence. There is also a need to protect our pension savings, which are now heavily invested in private equity. In short, we need a proper supervisory system for the financial services sector in Europe.
There is still a lot of talking to do. Serious discussions are needed to reach EU-wide and inter-governmental agreements, and to encourage the US to move in the same direction. But, for the sake of our pensions, our savings, our jobs, and our welfare states, the sooner change comes, the better.
Poul Nyrup Rasmussen is President of the Party of European Socialists and a former Danish Prime Minister. This commentary is published by DAILY NEWS EGYPT in collaboration with Project Syndicate/Europe’s World (www.project-syndicate.org and www.europesworld.org).
